Although bank loans themselves are somewhat illiquid because of private information, most of their cashflows are not. Recent financial innovations allow commercial loans to be liquefied via credit derivatives and actual and synthetic securitizations. The loan originating bank holds the remaining illiquid tranche containing the concentrated credit risk, private information rent and the “excess spread” that incentivize the bank to continue to monitor and service the loans. Empirically, we find that the average size of the residual tranche is about 3%, which reflects the size of the “market determined capital” necessary to support the liquefaction. The liquefaction of bank loans makes possible a banking system that restricts the guaranteed accounts to be backed by 100% reserves and the non-guaranteed deposits to be backed by liquid securitized loan tranches, while retaining the deposit-lending synergy. Such a system is perfectly safe without deposit insurance and it renders banks bankruptcy-remote without sacrificing a bank’s traditional role as a financial intermediary.

It is commonly argued that poorly designed banking system safety nets are largely to blame for the frequency and severity of modern banking crises. For example, “underpriced” deposit insurance and/or low reserve requirement are often viewed as factors that encourages risk-taking by banks. In this paper, we study the effects of three policy variables: deposit insurance premia, reserve requirement and the way in which the costs of bank bailouts are financed. We show that when deposit insurance premia are low, the monetization of bank bailout costs may not be more inflationary than financing these costs out of general revenue. This is because, while monetizing the costs increases the inflation tax rate, higher levels of general taxation reduce savings, deposits, bank reserves, and the inflation tax base. Increasing the inflation tax rate obviously raises inflation, but so does an erosion of the inflation tax base. We also find that low deposit insurance premia or low reserve requirements may not be associated with a high rate of bank failure.

Although bank loans themselves are somewhat illiquid because of private information, most of their cashflows are not. Recent financial innovations allow commercial loans to be liquefied via credit derivatives and actual and synthetic securitizations. The loan originating bank holds the remaining illiquid tranche containing the concentrated credit risk, private information rent and the “excess spread” that incentivize the bank to continue to monitor and service the loans. Empirically, we find that the average size of the residual tranche is about 3%, which reflects the size of the “market determined capital” necessary to support the liquefaction. The liquefaction of bank loans makes possible a banking system that restricts the guaranteed accounts to be backed by 100% reserves and the non-guaranteed deposits to be backed by liquid securitized loan tranches, while retaining the deposit-lending synergy. Such a system is perfectly safe without deposit insurance and it renders banks bankruptcy-remote without sacrificing a bank’s traditional role as a financial intermediary.